Capitalism: A True Love Story

How is wealth created? Seemingly a strange question for Forbes readers, but the question is hardly an academic one in the wake of the credit crisis and ensuing global recession. It has profound political implications that will affect our economic future.

Clearly, a sizable portion of the assets created in recent years turned out to be "make believe," the result of an unsustainable, ephemeral bubble in housing and the churning out of increasingly exotic, ultimately toxic financial instruments. It’s one thing for folks and institutions that hold suspect paper to lose out, but it’s quite another when the process that created the stuff ends up undermining the global financial system and battering the lives of hundreds of millions of other people. The notion that wealth creation, while desirable for enjoying a higher standard of living, is morally suspect has thereby gained new ground. Consequently, the critical foundation of economic growth has become more vulnerable to populist politicians and expansion-minded governments.

Even those individuals not normally hostile to free markets now hold suspicions that capitalism is fundamentally based on greed and is immoral; that it enables the rich to get richer at the expense of the poor; that free markets are Darwinian places where the most ruthless operators unfairly crush smaller competitors and where the cost of vital products and services, such as health care and energy, are almost beyond the reach of those who need them; and that capitalism unchecked breeds corruption à la Bernie Madoff and Enron and encourages obscene bonuses, excessive pay packages and unwarranted golden parachutes. Capitalism is also being blamed with renewed vigor for a range of social ills, from air pollution to obesity.

Well before the economic crisis intensified the drumbeat against "greed" and "free markets" on the part of the media and politicians, many people, including an astonishing number in business itself, didn’t have a clear understanding of just what constitutes a "free" market. This is why they blame capitalism for economic disasters, such as the recent mortgage meltdown and the astronomical cost of health insurance, when those disasters have in fact been caused by the government’s not allowing markets to function.

Let’s set the record straight: Far from having failed, democratic capitalism is the world’s greatest success story. No other system has improved the lives of so many people. The recent turmoil by no means mitigates the explosion of prosperity that has taken place since the early 1980s, when President Ronald Reagan enacted pro-market measures–low tax rates and less stringent regulation–that unleashed job-creating capital. The result: a surging economy that produced a flood of innovation, from personal computers and cellular phones to the Internet. Not only "the rich" but people at all income levels are today doing better.

The success of the U.S. did not go unnoticed. Free-market economic reforms–especially since the fall of the Berlin Wall–have brought an unprecedented surge of wealth to India, China, Brazil and nations in central and eastern Europe as well as in Latin America and Africa. Capitalism has helped usher in an era of wealth and economic growth that foreign-aid programs have tried but failed to do since World War II. The current recession should be seen historically as an interruption of, not an end to, this extraordinary expansion.

What’s getting lost in the crisis and the political turmoil is that capitalism is based on trust. Transactions in free markets are about achieving the greatest possible advantage, but that advantage must be mutual. To cite Adam Smith’s classic example, the baker or the butcher sells you food in exchange for your money. True, as Smith points out, this relationship is based on self-interest: They provide your dinner because they seek your money. However, for a transaction to occur, each party must benefit.

How does this take place? That’s the miracle of the free market–it just does. Free markets are spontaneous. No central planner or bureaucrat is needed to determine the needs of others–or how they must be met. A classic illustration of how the invisible hand mobilizes people and resources is found in the essay "I, Pencil: My Family Tree as told to Leonard E. Read," written by Read and often cited by the late Milton Friedman and other free-market economists. It should be a part of every school’s core reading curriculum.

The pencil narrates the story of how it came to be. It started out as a tree–"a cedar of straight grain that grows in Northern California and Oregon." The pencil goes on to describe the countless people and processes involved in its production–from cutting and transporting logs to supplying electrical power to mining graphite and extracting the rapeseed oil from the Dutch East Indies that is used in the process of making erasers.

Actually, millions of human beings have had a hand in my creation, no one of whom even knows more than a very few of the others. Each one wants me less, perhaps, than does a child in the first grade. Indeed, there are some among this vast multitude who never saw a pencil nor would they know how to use one. Their motivation is other than me. Perhaps it is something like this: Each of these millions sees that he can thus exchange his tiny know-how for the goods and services he needs or wants. I may or may not be among these items.

There is a fact still more astounding: the absence of a mastermind, of anyone dictating or forcibly directing these countless actions which bring me into being. No trace of such a person can be found. Instead, we find the Invisible Hand at work.

This is how wealth is produced in society: Countless individuals seek to meet their own needs by meeting the needs and wants of others. That’s indeed the moral basis of capitalism. It is the antithesis of greed. Forming networks of cooperation, individuals create businesses that produce innovations–not just pencils but inventions ranging from laptops to washing machines. In the process of providing for themselves, people generate the capital and innovations that yield economic growth, improving living standards and enabling society to advance.

When there is a need, entrepreneurs–appearing seemingly out of nowhere–will step in to fill it.

As one of the literally millions of examples, take what happened in the 1980s, after budget cuts forced the U.S. Coast Guard to scale back on some of its services. The Coast Guard could no longer provide nonemergency marine assistance to recreational boaters. Almost immediately, small entrepreneurs took up the slack. In Southold, N.Y. Captain Joseph J. Frohnhoefer Jr. founded Sea Tow Services International Inc., a AAA-like organization for boaters. His small business grew from a single vessel into a thriving franchise network with 108 locations throughout the U.S., Australia, Europe and the Caribbean.

Before Frohnhoefer and other entrepreneurs appeared, government was thought to be "needed" to ensure recreational boater safety. But Frohnhoefer’s private-sector business filled this need just as well as, if not better than, the government. The Sea Tow network is now called in to assist the U.S. Coast Guard in finding lost boaters, with boating accidents and on major emergencies–it aided in the recovery of victims in the crash of TWA Flight 800 and on 9/11. But the business is more than a private version of the Coast Guard and offers a variety of other services, such as boat financing and insurance.

Even those who hate capitalism are served by it–look at Michael Moore, who’s raking in millions of bucks with his new anticapitalist propaganda film, Capitalism: A Love Story.

Former U.S. ambassador, noted theologian and author Michael Novak points out: "The capitalist economy is not characterized, as Marx thought, by private ownership of the means of production, market exchange and profit. All these were present in the pre- capitalist aristocratic age. Rather, the distinctive, defining difference of the capitalist economy is enterprise: the habit of employing human wit to invent new goods and services, and to discover new and better ways to bring them to the broadest possible public."

There will, of course, be criminals and greedy individuals in a free-market economy, just as there are in all walks of life and at all times. That is where government is critical to the free market–to enforce contracts, protect property rights and maintain order, as it does in the rest of society.

Now, all this will seem self-evident to a lot of you. But make no mistake, these basics are not understood by many people, certainly not most politicians and economists. That’s why there’s a deep belief that government itself can create wealth. It can’t. It can bestow wealth by taking resources away from others. It can redistribute wealth, but it can’t create it as the private sector can and does. Stimulus programs à la President Obama’s? They have rightly been compared to using a pail to move water from one end of a pool to another. The exercise doesn’t increase the amount of water in the pool.

The severe credit crisis that hit a year ago enormously damaged the reputation of entrepreneurial capitalism, even though government actions brought on the disaster. Wall Street, despite its egregious behavior, no more caused this debacle than OPEC caused the Great Inflation of the 1970s.

Whenever the government prints too much money, bad and strange things will happen. The particulars may change, but the result is always baleful. The housing bubble could never have grown to the size it did had the Federal Reserve not printed so much money and kept interest rates artificially low for so long. The fuel would not have been there to produce it. Compounding this felony were Fannie Mae and Freddie Mac, so-called government-sponsored enterprises that by the end of 2007 held some $1.6 trillion in low-quality paper. These two entities achieved their monstrous size and malignant and distorting influence precisely because they had the implicit guarantee of Uncle Sam and were exempt even from normal, basic reporting requirements to the SEC.

Mark-to-market accounting rules, which the government imposed in 2007, forced banks and life insurance companies to write down the value of their regulatory capital as if it were a day-trading account. Previously, capital was assessed at book value for regu-latory purposes, that is, at the price for which the institution bought it. Thus, most of the hundreds of billions of dollars of losses these financial institutions reported were not actual cash losses but artificial book losses. It’s no coincidence that when mark-to-market accounting was modified this spring the equity markets, led by financial companies, took off like rockets from their lows.

The SEC’s removal in 2007 of the uptick rule (which held that a stock couldn’t be shorted unless it had gone up in price), as well as its failure to enforce the rule against naked short-selling (an investor is supposed to borrow the shares before he shorts them), increased pressure on beleaguered banks and insurance company equities.

Thus, what began in August 2007 was not the failure of free markets but the result of bad government actions: Greed and recklessness always run rampant during a bubble. In fact, the two biggest economic disasters of the 20th century–the Great Depression in the 1930s and the Great Inflation of the 1970s–were both the result of catastrophic government mistakes, not a sudden failure of free-market capitalism.

The Depression was triggered by the Smoot-Hawley Tariff Act of 1929–30, which imposed enormous taxes on hundreds of imports. This detonated a global trade war that dried up world commerce and the flows of capital. President Herbert Hoover deepened the economic slump with huge tax increases. Franklin Roosevelt’s policies, which included even more tax increases, severely hampered recovery.

The Great Inflation of the 1970s was caused by repeated bouts of excessive money printing by the Federal Reserve and other central banks in the mistaken belief that government could eradicate the normal ups and downs of economic activity.

Apologists for big government make the point, for instance, that in the 19th century U.S. railroads received massive subsidies from the federal government in the way of land grants and federal loans. Isn’t that proof that government is a needed catalyst for economic progress? No, it isn’t.

Government-aided railroads all went through one or more bankruptcies. The workmanship of the construction was often shoddy, and costs always exceeded estimates. Some historians call the creators of these railroads "political entrepreneurs," because they weren’t the genuine article. Commercial entrepreneurs, such as James J. Hill, who put together the mighty Great Northern Railway, never took a dime in government subsidies and never went broke. The rails were laid, and the customers were well served. Hill’s enterprise was a prodigy of productivity and innovation. Washington played no role.

Government’s task should be to create a stable, hospitable environment for economic activities–allowing businesses to be businesses and entrepreneurs to take risks and invest in job creation. The government’s policies should be devoted to ensuring that the following conditions are present in the economy:

—The rule of law. A vibrant economy requires that the terms of commercial contracts are respected and enforced and that everyone, including politicians and government bureaucrats, abide by those terms. When rights are violated, people and businesses have recourse in a fair and judicious court of law. The rule of law should guarantee that officials cannot act arbitrarily, as Argentina’s government did recently when it seized the private 401(k)-style pensions of its citizens. Arbitrary, capricious government is a major reason that Argentina has a lagging, perennially troubled economy and that it’s no longer one of the richest nations in the world, as it was 100 years ago.

The U.S., by contrast, has long been a magnet for foreign investment because its legal system assures a relatively safe haven for investors. Government cannot suddenly seize your property or nationalize your business in the U.S.

—Respect for property rights. Property rights are a critical part of the rule of law. If you own a business, an object, a piece of land, a house or a building, you should not have to fear that an envious or angry government might one day seize it arbitrarily. If a society doesn’t have strong property rights, risk-taking declines. Entrepreneurs are then forced to protect their property by buying influence with the political powers that be, wasting time and resources that would otherwise be devoted to growth-producing enterprises.

Property rights help create prosperity because they allow people to use what they own as collateral. Land and buildings become not just utilitarian items but also sources of capital.

Several years ago noted economist Hernando de Soto calculated that 4 billion people in the Third World and former communist nations owned real estate worth $9 trillion. But because of weak property-rights systems, this real estate was, as de Soto put it, "dead capital." Imagine how much of the world’s poverty would be reduced if people were able to fully mobilize these trillions of dollars in assets.

—Stable money. A strong and stable currency is why the U.S. did better after achieving independence from England than the nations of Latin America did after breaking away from Spain and Portugal.

—A pro-growth tax system. Taxes are a price and a burden. Low tax rates on income, profits and capital gains foster more risk- taking and higher growth, bringing about a richer economy with a higher standard of living–along with higher government revenues.

—Ease in starting a business. We, in the U.S., take this for granted. Starting a legal business here is fairly easy to do, but in numerous other countries the process is time-consuming and expensive, requiring multiple licenses and procedures and the involvement of multiple government agencies.

Several years ago Bulgaria’s new prime minister, Simeon Saxe-Coburg-Gotha, was shocked to discover that an entrepreneur in his country had to obtain 17 government permits in order to start a business. One of his goals became making new-business formation easier through "one-stop shopping" for the necessary permits. Bulgaria simplified the process of starting a business and helped enlarge its formal economy.

—Few barriers to doing business. Politicians may peddle protectionist tariffs, quotas or "safety" regulations as "helping the economy," but these are more often acts of political favoritism, rewarding one or another special interest. They raise the cost of economic activity and allow less of it to take place. For decades Japan was notorious for barring imports of U.S. beef, ostensibly on the grounds of safety, but everyone knew it was for political purposes.

Barriers also exist within domestic economies. The U.S. is hardly a paragon of virtue when it comes to states abusing licensing procedures to protect politically connected incumbent businesses.

So where do we go from here? Free enterprise is temporarily under a cloud, but remember it’s just that–temporary. What we are witnessing now is an Administration that is doing all it can to expand government domination of the economy. This is the last stand of 20th-century statism, the idea that free-market economies are inherently unstable and thus must be guided or even dominated from the commanding heights of a powerful government.

The notion that a handful of mandarin-like bureaucrats can constructively guide the economy; run our health care system; provide old-age pensions without having accumulated reserves during our working lives; fine-tune our financial system; dole out student loans; and engage in tens of thousands of countless other activities is preposterous. (In the ultimate absurdity the Federal Reserve is even proposing that some 5,000 banks and other financial firms be regulated on how to compensate employees and executives so as to avoid "excessive risk-taking." This is beyond parody.) Experience shows that in managing or overseeing most things, government is suffocatingly incompetent. This also flies in the face of the liberating ethos of the ever-growing World Wide Web.

Washington’s actions are generating a severe political reaction. The statists have overplayed their hand. The ultimate triumph of the principles of free-market capitalism, however, is not going to come without serious cost. The statists in Washington and elsewhere are doing–and will continue to do–immense harm before they are swept away. In great wars–the American Civil War, the First and Second World Wars–the largest casualties are suffered just before the conflicts end. We saw the peacetime economic equivalent in the 1970s and early 1980s, during which unemployment in the U.S. reached 11% and short-term interest rates touched 21% before President Reagan decisively broke the inflationary fever. His policies of stable money, low tax rates and a muscular military and foreign policy enabled the U.S. to quickly recover and surge ahead so powerfully that 20 years later the U.S. share of global GDP had increased.

The White House is continuing the Bush Administration’s disastrous weak-dollar policy. Federal Reserve Chairman Ben Ber-nanke is as blind on this as are Treasury Chief Timothy Geithner and White House economic czar Larry Summers. Even Bill Clinton knew that, for political reasons, a feeble greenback is political poison. Yet the lessons of the Jimmy Carter years are lost on this crowd.

Rule of law? With GM, Chrysler and home mortgages, the Administration is trashing it Argentina-style.

Regarding trade, Barack Obama is on his way to becoming maybe the worst White House occupant since Herbert Hoover. The magnitude of Obama’s transgressions with Mexican trucking and Chinese tires are, in a narrow way, small. But they signal to the world that the U.S. is abandoning its 60-year tradition of free-trade leadership. The result will be lethal: everyone for himself–something the world hasn’t experienced since the 1930s.

Americans are sensing that something is profoundly wrong in all of this, particularly with regard to the weak dollar. Occasionally I speak at motivational events that are attended by thousands of people, and these people respond resoundingly to the call for a strong greenback. You don’t have to grasp the basics of entrepreneurial capitalism to understand that most of what the Obama Administration has undertaken will do more harm than good.

The cliché that it’s always darkest before the dawn is true. So hold on. Just as happened under Reagan, a bright, new day is beckoning. But this time entrepreneurs and others will have to take on an additional task–making sure that more people learn about the basics of our free-enterprise system.

This and other themes about capitalism are covered in the forthcoming book, (Nov. 3), How Capitalism Will Save Us: Why Free People and Free Markets Are The Best Answer In Today’s Economy, by Steve Forbes and Elizabeth Ames (Crown Business).